Corporate Finance: The Project

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 Part I
CORPORATE GOVERNANCE ANALYSIS

The purpose of this section is to understand the relationship between managers and
stockholders.
A. Managers and Stockholders
Due to the prevalent problems associated with agency issues, when analyzing a company
it is important to understand the relationship between managers and stockholders. Information
on the Chief Executive Officer and the Board of Directors allows us to discern that the
incumbent managers of our oil companies are more focussed on the pursuit of self-interests than
on maximizing shareholder value.

Chief Executive Officers:

Amoco Chevron Mobil Exxon Texaco Industry

Average
Name Laurence Kenneth Lucio A. Lee R. Peter I.
Fuller T. Derr Noto Raymond Bijur
Age 58 60 59 58 55
Years at the Company 36 38 36 34 31 29
Years as CEO 6 9 4 4 1
Studies BSCE BSME MBA ’62 Ph.D. ‘63 MBA’66 -----
’61 ’59, Cornell U of Columbi
Cornell MBA ’60 Minnesota a
Cornell
CEO Compensation
Salary rank out of 48 17 9 10 1 12
CEOs in Oil Industry
Salary rank out of 800 260 195 210 57 215
CEOs
Salary (thou) $969 $1,154 $850 $1,550 $639 $641
Bonus (thou) $917 $1,200 $650 $1,250 $939 $655
Other (thou) $121 $1,533 $1,275 $638 $43 $338
Stock Gains (thou) $956 ----- $884 $5,853 $1,969
Total Compensation $2,963 $3,887 $3,659 $9,291 $3,590 $2,383
(thou)
Stock Ownership (% 0.02 0.02 0.02 0.06 0.03 0.08
of Total)
Market Value (mil) $6.8 $8.5 $9.5 $12.1 $6.9 $5.9

2
 It is interesting to note that overall the CEOs have a long history with their respective
companies averaging 29 years as employees and 4 years as CEOs. While it is likely that their
years of inside experience amassed them sharp understandings of their companies it is difficult to
gage their efforts in maximizing firm value. The power of the CEOs is certainly manifested by
their large compensation packages averaging $4.678 mln in 1997 (which is twice the industry
average of $2.383 mln). In fact, according to Forbes these CEOs rank in the top third of their
industry (based on compensation) with Exxon, Chevron and Mobil ranking in the top 10. A
further study comparing the compensations of 800 top executives again places them in the top
third. Their power, however, does not emanate from their stockholdings that average only
0.03%. This separation of management and ownership detracts from the power stockholders
have over the CEO and suggests little incentive for the CEOs to focus on increasing shareholder
value.

Boards of Directors:

Amoco Chevron Mobil Exxon Texaco

Number of Members 15 12 15 12 17
Insiders 2 2 4 2 2
CEO of other Companies? 6 9 5 5 6
Related Companies? No Yes Yes No No

A review of the Boards of Directors provides only minimal clear and compelling
evidence that managerial interests dominate. First, none of these companies are listed on
Calper’s 1997 or 1998 watch lists. Second, we are not aware of any actions by management
where stockholder’s interests were clearly violated such as greenmail, large increases in
compensation while stock price was dropping, or the acceptance of low prices/rejection of high
prices in takeover battles. Third, surprisingly, the Boards of Directors have very few insiders
and are therefore less likely under the influence of the CEOs. For most boards, however, about
half the members are CEOs at other organizations. Therefore, it is likely that their loyalties as
board members of the oil companies will really depend on whether or not the oil company’s
CEO sits on the board of the company they manage. Because they sit on each other’s boards,
they are not truly independent monitors and cannot be fully protecting shareholders’ interests. In
addition these CEOs most probably will not have the time, information and interest in being
involved with internal issues.

3
B. The Firms and Financial Markets:

Amoco Chevron Mobil Exxon Texaco

Num. of Analysts 55 59 58 22 62
Analysts Recommendations (%)
Buy 16.67 23.53 39.13 27.27 47.06
Hold 83.33 64.71 52.17 63.64 41.18
Sell 0.00 11.76 8.7 9.09 11.76
Daily Average Trading Volume ($mln)
1998 (Jan.) 22.0 33.6 68.5 68.3 44.6
1997 17.0 29.4 69.9 70.3 35.96
1996 18.3 27.8 57.6 66.6 36.42
1995 14.1 20.0 48.4 52.6 25.37

We can infer from the fact that these oil companies are followed by a large number of
analysts that they are more careful in their dealings with markets than industries followed by
fewer analysts. The lower percentage of “sell” recommendations suggests that, although oil
companies are well known and closely followed by the media, there is still the possibility of
retaliation, which cause the release of biased information. However, there is a lot of information
available in addition to that provided by the firms about themselves, which mitigates the
aforementioned biased information.

C. The Firms and Society:

Companies in the highly regulated oil industry are conscience of their public image and
potential negative press for failure to meet environmental restrictions. This is evident, not only
by the emphasis these companies put on environmental efforts in their Annual Reports, but also
by the contributions they make to environmental organizations and the publicity they demand for
related awards or merits.
In the past couple of decades, particularly due to the rise in environmental awareness,
society at large has been scrupulously monitoring these companies’ activities. While over all,
the EHS’ (Environment, Health and Safety) continuos control keeps these companies in-line,
there have been a number of questionable activities or irresponsible errors that created some
tension between the oil industry and public.

4
Amoco: Amoco, aware of its environmental obligations, has incorporated societal concerns into
its overall strategy. The company’s objective (according to the Annual Report) is to integrate
environment, health and safety considerations into the firm’s everyday operations. It therefore
introduced several projects to make health and safety information more accessible and more easy
to understand. In addition, last year Amoco Foundation Inc. contributed more than $19 million
to community and educational organizations in 27 countries. Amoco spent four years developing
a new alternative fuel for diesel engines that has ultra-low emissions. In July 30th 1997, Amoco
Corporation's refinery earned Star status under the Occupational Safety and Health
Administration (OSHA) Voluntary Protection Program because of its top-notch employees and
safety procedures. The refinery is one of just 260 industrial facilities nationwide, and the only in
North Dakota, to be selected for the award that reduces its re-audit period for safety procedures
to every third year instead of annually.

Chevron: Chevron too has earned a positive reputation despite some negative press. In 1997
Chevron received the National Health of the Land award presented by the Bureau of Land
Management for the Eastern US for outstanding environmental practices. Additionally, the
Wyoming Wildlife Federation named Chevron its 1996 Corporate Conservationist of the Year,
citing its contributions to numerous projects including an air pollution study on Elk and deer
refuge. Like Amoco, Chevron had one of its chemical plants acknowledged by the Occupational
Safety and Health Administration for out standing safety processes. In fact, safety is such a
priority that annually employees participate in dozens of drills to prepare for possible spills, fires
and other emergencies. Also in 1996, Chevron reduced its sulfur oxide emissions at its NJ
facility by about 200 tons per year. Overall, its SMART program (Save Money and Reduce
Toxics) has cut hazardous waste disposal 60% since 1987.
Chevron also regularly contributes to many organizations, like to the Wildlife Fund in
New Guinea, to develop sustainable plans for oil discovery. Its Rigs to Reef program (where
decommissioned oil platforms are toppled) in the Gulf of Mexico supports three fourths of all
commercial and sport fishing in the Gulf. Its own employees even volunteer helping restore
parks (like Yosemite) and participating in West coast beach cleanups.

5
 Chevron relationship with society has been strained due to negative press. For example,
as recently as May 1997, Chevron spilled 25,000 gallons of oil into public waters in Pearl Harbor
and had spilled 8 times that amount over the prior year. In 1996 it paid $700,000 in penalties for
violating the sulfur oxide emissions regulation. Going back to 1993, one of its refineries paid a
fine of $1.5 million, the largest assessed by the EPA in the last decade for a single facility, for
illegally dumping pollutants and it was alleged to have leaked millions of gallons of oil into the
ground beneath that facility. Also in 1993 one of its facilities was plagued with criticism over its
toxic air emissions, as well as its discharge of toxic wastewater.

Mobil: Environmental groups have also praised Mobil, such as the Environmental, Health &
Safety (EHS) for the steps it has taken “to reinforce its culture of operating safely and practicing
sound environmental stewardship." Among its environmental actions, Mobil put into service the
Raven, its second double-hulled enormous crude carrier and has two others are on order. Such
vessels reduce the risk of spills caused by accidental groundings or collisions.

To heighten internal awareness, the company adopted a new policy entitled Mobil's
Commitment to the Environment, Health & Safety, which spells out principles and commitments
to ensure further improvement in Mobil's EHS performance. "The policy makes every Mobil
employee and contractor responsible for protecting the environment and the health and safety of
our people, our customers and the communities in which we work," said Dalgetty, the General
Manager of the EHS. "No one can claim that these responsibilities are someone else's job."

The policy also serves as the foundation of the Mobil EHS Management System, which
establishes certain expectations of how company facilities throughout the world must operate.
The system provides employees with a better understanding of how their actions affect
EHS performance.

Exxon: Exxon experienced an oil spill disaster ten years ago and for along time had its name
associated with environmental recklessness. By now the company has regained its strong
reputation. It has been described in a recent EHS report as having the best performance ever in

6
personnel safety (as measured by lost time incident rate), a 20% decline in operating incidents,
and a Marine Vessel Oil Spill rate of less than 1/10 of a pint per gallon transported.

Texaco: As do the other oil companies, Texaco uses the EHS (Environmental, Health and
Safety) Auditing Program. As a result, between 1989 and 1996, it reduced chemical releases by
more than 80%, brought down incidents of leaks and spills to 37% and dropped the volume of
the spills to only 20%. Additionally, in an effort to conserve resources and minimize waste
Texaco began re-injecting into underground reservoirs the water used in oil production.

7
 Part II
STOCKHOLDER ANALYSIS
The purpose of this section is to understand who are our companies’ marginal investors.

Amoco Chevron Mobil Exxon Texaco

Latest Public Offer 9/59 6/63 N/A. 2/70 9/66
Shares Offered 152,100 125,000 N/A. 8.600.000 200,000
(split adj.
250,000)
Share Price 42.5 $62.38 (split N/A. $45 $63.25
adj: $31.19)
Type Common Common N/A. Common Common

Insider trading net dollar value buys and sells as of 1/14/98 (1985 to present in dollars)
Date 5/95 10/96 5/95 2/98 6/89
Lowest Activity -2.02 MLN -1.42 MLN -4.12 MLN -14.65 MLN 2.05 BLN
Date 8/95 4/96 11/95 8/93 1/88
Highest Activity 639,400 19.30 MLN 924,540.00 320.65 MLN 197.75 MLN
Mean 261,099 958,226 -210,670 -2.39 MLN -44.72 MLN
Most recent 45 0.00 0.00 0.00 -14.5 MLN 0.00
days
Institutional ownership
# of Buyers 373 403 518 571 364
# of Sellers 381 306 393 524 434
# of Holders 907 880 1,058 1,212 856
Shares Held 276.34 MLN 328.14 MLN 416.66 MLN 1.03 BLN 330.22 MLN
% Shares 56.75 49.96 53.12 41.66 60.26
Outstanding
Shares Sold 12.97 MLN 26.63 MLN 3.68 MLN 35.67 MLN 20.71MLN
Top State ST Merrill Lynch Vanguard G. Vanguard G. Capital Rsch.
Institutional BK&TST Cap. MK Merrill Lynch Putnam Inv. MGM
Holder
Percentage 6.74 (9/97) 4.77 (9/97) 0.65 (12/97) 0.65 (12/97) 5.35 (9/97)
# of Inst. 1 0 0 0 1
Over 5%
Foreign USA USA USA USA USA
Listings Canada Germany Germany UK Canada
Germany UK Japan Germany Switzerland
Switzerland Switzerland UK Japan Belgium
Canada Switzerland UK
Switzerland

8
 The various companies’ stockholders are fairly dispersed with institutional owners
holding around 40% of the oil companies’ total stocks outstanding. The number of institutional
investors owning greater than 5% of the outstanding shares are no more than 1 per company.
This suggests that the marginal institutional investor is diversified. The remaining 60% of
investors, who are not institutional, are most likely individuals who tend to prefer dividends
(which will be explained further in sections VIII and IX). The following sections will evaluate
the companies based upon models that rely on these assumptions.

9
 PART III
RISK PROFILE

In this section we address the risk profile of the companies analyzed, compare it to the
industry averages and calculate the hurdle rates for the firms.

I. - Market analysis of risk and return in the oil industry

1) Calculating Top-Down Betas:
For each company we ran a regression of the individual stocks monthly prices against the
S&P 500 index for the period 1993 to 1998. The results of the regression on which we
concentrated were the intercept (to calculate the Jensen’s alpha), the slope (beta/risk), the R-
squared (to understand how much of the risk is diversifiable) and the standard error of the Beta
(to assess the validity of the top down prediction). The results are highlighted in the following
table.

Amoco Mobil Texaco Chevron Exxon

Jensen’s alpha -1.19% 4.94% 1.69% 4.28% 0.02%
Beta 0.50 0.54 0.46 0.55 0.74
R2 12% 18% 11% 15% 38%
Stand. Error 0.16 0.15 0.17 0.17 0.13

a) Intercept: The intercepts of the regressions were compared with:

Risk-free rate x (1-Beta)

In this equation the risk-free rate is the short-term monthly risk free rate (0.41%) which yields a
5% rate on a yearly basis. The difference
[Intercept – Rf x (1-Beta)]
once annualized, gives us the Jensen’s Alpha or the measure of the performance of each
company’s stock on a yearly basis. If positive, the stock performed better than expected by the
market.

10
 Our Jensen’s alpha figures indicate that in general, the companies’ stocks performed
better than expected during the period of the regression. This reveals that the overall industry is
experiencing a positive momentum and the market underestimates the returns on these stocks.
Amoco Mobil Texaco Chevron Exxon
Jensen’s alpha -1.19% 4.94% 1.69% 4.28% 0.02%

b) Slope: The slope of the regressions gave us the beta of the companies (their risk level). The
figures reveal that the firms analyzed are below average risk (Beta = 1). This is most probably
due (as addressed later in the analysis) to steady earnings and low debt ratios.
Amoco Mobil Texaco Chevron Exxon
Beta 0.50 0.54 0.46 0.55 0.74

c) R2: The R 2 indicates that the greatest part of the risk faced by the companies comes from firm
specific sources (which is diversifiable). This is somehow surprising as the fortunes of these
companies depend on factors such as oil prices and general macroeconomics trends. It is also
arguable however that the companies’ operations involve high levels of risk of catastrophes
(which is intrinsic to each firm’s safety policies). The Exxon Valdez disaster is a concrete
example possibly explaining the low values of the R2.
Amoco Mobil Texaco Chevron Exxon
R2 12% 18% 11% 15% 38%

d) Standard Error: Finally, the standard errors of the betas are low enough to allow us to
consider these figures reliable and therefore to use them in the analysis as we proceed further.
Amoco Mobil Texaco Chevron Exxon
Stand. Error 0.16 0.15 0.17 0.17 0.13

2) Identifying the Financial Leverage Effect on Betas:

In order to understand the importance and role that financial leverage plays in assessing
the level of risk of the companies, we calculated the value of the companies’ unlevered betas.

11
For the calculation we used the market value of debt and equity in order to come up with the D/E
ratio to apply in the formula:
Unlevered Beta = Levered Beta/[1+(1-marginal tax rate) x D/E]

The specific calculations for the market value of debt and equity are detailed in the
section “Market value of debt and equity.” We used a marginal tax rate of 35%, which was
common across the companies. The values are:

Amoco Mobil Texaco Chevron Exxon Ind. Avg.

Unlevered Beta 0.46 0.49 0.39 .50 0.70 0.54
Market value D/E 13.11% 15.69% 27.11% 13.11% 9.56% 55%
Beta 0.50 0.54 0.46 0.55 0.74 0.74

As shown in the table, the companies’ betas are generally lower than the industry
average. This is probably due to the considerable sizes of the companies analyzed and to their
mature stages. The difference between the unlevered and the levered betas shows that debt does
not play an important role. Most of these companies’ risks, in fact, are due to business-related
factors and only a smaller portion to financial leverage (which is pretty low for the five
companies compared to the industry average).

3) Bottom-up Beta Estimate:

Although the betas resulting from the regression are on average good estimates of the
companies analyzed, because of the low standard errors we also calculated the betas using the
bottom-up method. Most companies are not solely involved in the exploration and production of
oil, refining and marketing. The production of chemicals and other operations (coal, coke, and
power) represent a growing part of the overall businesses of these oil companies. We then
proceeded to calculate the bottom up beta and compared it with the beta that resulted from the
operation.

We divided the companies into their main businesses and calculated percentage weights
based on each business unit’s operating income.

12
 Business Units Average Amoco Mobil Texaco Chevron Exxon
Unl. Beta (% of NI) (% of NI) (% of NI) (% of NI) (% of NI)
Exploration and 0.55 64.4% 63.4% 75.8% 77.5% 50.0%
Production
Refining 0.54 11.5% 27.4% 24.2% 14.14% 5.00%
Chemicals 0.65 24.1% 9.20% 0% 6.75% 33.00%
Cole and Coke 0.69 0% 0% 0% 1.61% 12%

The weighted (by the % of net income) averages of the unlevered betas allowed us to
calculate the bottom-up betas by again levering the betas with the current market value D/E ratio
of the individual companies. Let’s compare the results with the top down beta figures.

Amoco Mobil Texaco Chevron Exxon

Top down Beta 0.50 0.54 0.46 0.55 0.74
Bottom up Beta 0.62 0.61 0.64 0.60 0.64
Industry avg. Beta 0.74 0.74 0.74 0.74 0.74

The bottom-up beta estimates are higher than those of the top-down method (with the
exception of Exxon that is equal to the industry average). However, as previously stated, the
Top-Down Betas are reliable because the standard errors of the betas from the regressions are
low and none of the companies restructured themselves substantially during the regression
period. We therefore will stick with those estimates.

4) Market Value of Equity and Debt:

Before introducing the cost of capital analyses for our companies, we will explain the
calculation and the significance of the market value of both equity and debt. These figures are
the basis for the levered and unlevered beta computations of previous sections and for the final
calculations of the costs of capital.

a) Market value of equity:

By multiplying the number of shares outstanding in the market at the end of the examined
period and the market price of each stock for the same period, we calculated the market value of
equity for each firm (in thousands of dollars).

13
 Amoco Mobil Texaco Chevron Exxon
Market value of equity 40,598 56,957 28,765 50,857 121,733

Market value of Equity (.000)

150

100

50

0
Amoco Mobil Texaco Chevron Exxon

MV of Equity

b) Market value of debt:

In order to estimate the market value of debt we needed the following data (in thousand
of dollars) to apply the formula:
( 1-(1+i)^(-n) )
MV of debt = Interest Expense * ------------------- + Book Value of Debt/(1+i)^n
i
where “n” is the average maturity of the debt and “i” is the current before tax cost of debt.

Amoco Mobi Texaco Chevron Exxon

l
Book Value of Debt 5,201 7,628 5,590 6,694 9,746
Current Int. Rate on Debt 6.2% 6.5% 6.8% 6.5% 6.2%
Avg. Bond Maturity (Yrs.) 8.33 8.92 14.8 11.5 8.2
Interest Expense 192 455 434 364 464
Market Value 4,372 7,260 6,083 6,304 8,863
Of Debt (a)
PV of Operating Leases (b) 951 1,680 1,715 641 2,779

Total Market Value of 5,353 8,940 7,798 6,946 11,642

Debt (a) + (b)

14
 Market value of Debt (.000)
12
10
8
6
4
2
0
Amoco Mobil Texaco Chevron Exxon

MV of Debt

♦ The book value of debt is the sum of short term and long term borrowings, including any
items highlighted in the notes of the financial statements such as “Throughput contracts” or
“Take or pay contracts”
♦ The current cost of debt calculation is detailed in the next section (“Cost of Capital”)
♦ The average maturity of the bonds is the weighted (by face value) average of the maturity of
the current bonds outstanding
♦ The resulting market value of debt has to be supplemented by the present value of the
operating leases. These charges were discounted at the above interest rate on debt.

We can now obtain the figures of the relative weight of equity and debt on the overall
firm value in market terms:

Amoco Mobil Texaco Chevron Exxon Ind. Avg.

Market Value of Equity (a) 40,598 56,957 28,765 50,857 121,733
Market Value of Debt (b) 5,353 8,940 7,798 6,946 11,642
Firm Value (a) + (b) 45,951 65,897 36,563 57,803 133,375
D/(D+E) = Kd 11.65% 13.57% 21.33% 12.01% 8.73% 18.33%
E/(D+E) = Ke 88.35% 86.43% 78.67% 87.99% 91.27%

The industry average debt ratio is higher than that of most of the companies analyzed.
Our interpretation is the same as when addressing the D/E ratios. Size and mature stage, as well
as other reasons discussed in the capital structure section, justify the below industry average
company figures in the above table.

15
5) Cost of capital:
The cost of capital is the weighted average cost of equity (Ke) and cost of debt (Kd). We
therefore address the calculation of Ke and Kd first and then conclude section III with our
analysis of the weighted average costs of capital.

a) Cost of debt:
In order to estimate the costs of debt for the five companies we followed these steps:
identify the bond ratings for the companies, determine the consequent spread and add the spread
to the long-term risk free rate (which we established in the beginning as the 6%).

Following are the details for each company:

Amoco Mobil Texaco Chevron Exxon

Bond Rating AAA AA A+ AA AAA
Spread (a) 0.20% 0.50% 0.80% 0.50% 0.20%
Risk Free Rate (b) 6% 6% 6% 6% 6%
Before Tax Cost of Debt 6.20% 6.50% 6.80% 6.50% 6.20%
(c) = (a) + (b)
After-tax Cost of Debt 4.03% 4.22% 4.42% 4.22% 4.03%
(c) x (1- 35%)

b) Cost of equity:
The cost of equity has various meanings. First, it represents the return that investors in
the individual companies require in order to purchase the stock. Second, it establishes the hurdle
rate that the company has to consider when evaluating the projects from an equity point of view
(i.e. when the cash flows considered are cash flows to equity). Third and the main purpose of
this section, the cost of equity is a fundamental input in the calculation of the cost of capital.

The cost of equity is:

Ke = Risk-free rate + Beta (Risk Premium)

We have come to the decision in the previous sections that the top-down beta from the
regression is a valid estimate of the companies’ risk level. The risk-free rate also has been
established earlier as 6% for long-term investors and 5% for short-term investors. The risk

16
premium used in the analysis is based on historical data revealing 5.5% premium as a reliable
estimate for long-term time horizon and 8.41% for short-term time horizons. Once determined,
the inputs for the cost of equity for the individual companies are summarized in the table below:

Amoco Mobil Texaco Chevron Exxon

Beta 0.50 0.54 0.46 0.55 0.74
Short-term Cost of Equity 9.21% 9.54% 8.87% 9.62% 11.22%
(8.41% premium)
Long-term Cost of 8.75% 8.97% 8.53% 9.02% 10.07%
Equity (5.5% premium)

For the purpose of this analysis, to estimate the value of the companies analyzed, we will
use the long-term cost of equity for the computation of the cost of capital. Exxon’s higher cost
of equity reflects a higher risk embedded in the company (underlined by the higher beta than its
competitors). Because of its higher risk, investors require a higher return for Exxon than they do
for other companies in the industry. At the same time, because the cost of financing the business
with equity is more expensive, the projects that the company undertakes should yield higher
returns than those of its competition. In summary, its hurdle rate is higher. The next session will
address some industry comparisons.

c) Weighted average cost of capital:

We now have all the inputs to solve the following equation that gives us the cost of capital:

WACC = Ke (E/(D+E)) + Kd (D/(D+E))

Following are the details of the calculations and the industry averages for each of the
inputs.

Amoco Mobil Texaco Chevron Exxon Ind. Avg.

Beta 0.50 0.54 0.46 0.55 0.74 0.74
Cost of Equity 8.75% 8.97% 8.53% 9.02% 10.07% 9.85%
E/(D+E) 88.35% 86.43% 78.67% 87.99% 91.27% 81.67%
After-tax Cost 4.03% 4.22% 4.42% 4.22% 4.03% 4.78%
of Debt
D/(D+E) 11.65% 13.57% 21.33% 12.01% 8.73% 18.33%
WACC 8.20% 8.34% 7.56% 8.45% 9.54% 8.92%

17
 WACC (%)

10

6
Amoco Mobil Texaco Chevron Exxon

WACC AVERAGE

All companies except for Exxon have a cost of financing their activities that is lower than
the industry average. Exxon’s higher beta again drives its cost of capital up compared to its
competitors. The other companies’ costs of capital are lower due to both their lower betas as
well as their higher average debt ratios.

18
 PART IV
INVESTMENT RETURN ANALYSIS

This section analyzes the quality of the firms’ current projects and the managers’ abilities
to contribute to increasing the firms’ values. We will also assess the quality of the companies’
future projects by considering what characteristics the investments have within the industry.

This analysis relies on the valuation of the returns of the projects based on accounting
methods. In particular the return on equity (ROE) and the return on capital (ROC), which we
will define briefly, will be compared to the current cost of equity in the first case, and to the cost
of capital in the second. This will enable us to determine whether the companies have excess
returns over costs.

a)Characteristics of the projects in the industry: the business units that petroleum companies are
typically involved in (identified in part 2) share some common characteristics, but at the same
time retain some peculiarities that makes it worthwhile to consider them separately. The issues
that we want to control which are related to the cash flows generated by the projects are: time
horizon, predictability, external variables affecting the patterns of the flow and currency the cash
flows are in.

Business Units Time Horizon Predictability External Variables Currency

Production and Very long term Difficult to predict Macro-economic Could be any,
Exploration and very high trends, oil prices, but mainly US
variability dollars
Refining and Medium/long Predictable Macro-economics Mainly local
Marketing term trends, oil prices, currencies
oil substitutes as
alternative source
of energy industrial
and capital goods
sector trend
Chemicals Long term Fairly predict Industrial goods Mainly US
sector trends dollars

19
 In general, the oil companies have a longer than average time horizon for their projects.
The up front investments are usually very high (billions of dollars) and the cash flows are not
very predictable. A positive note is that the companies hardly ever engage in projects that do not
pertain to their core businesses. Their experience allows them to mitigate the variability of the
return on these projects. This makes the cash flow patterns more predictable than the intrinsic
nature of the projects would make us think.

b)ROE and ROC analysis: this analysis looks backward to evaluate the companies’ past returns
on the capital employed in the firms. The ROE tells us the amount of income the company was
able to generate with the equity available. In a similar way, the ROC identifies how much return
the company was able to generate from the capital employed. In order to have stronger
explanatory power, these figures must be compared to the cost of equity (in case of the ROE) and
to the cost of capital (in case of the ROC). If the returns are higher than the costs, the companies
are able to generate excess returns possibly leading to increases in the firms’ values. Before we
look at the companies’ specific data, some background information is important.

The ROE was calculated as Net Income divided by the average (of the last two years)
book value of equity.

The ROC was calculated as EBIT x (1- tax rate of 35%) divided by the average (of the
last two years) book value of the firm (debt + equity).

For some of the companies, the ROE and ROC were fairly stable over the past few years.
For others they fluctuated a bit. For those firms where the figures were quite different in the last
few years, we also looked at the average ROE and ROC in the last 3 and 5 years in order to
obtain a measure that reflected past events. For the sake of simplicity, the cost of capital and
cost of equity has been assumed to be equal to that of the latest period. Even with those
fluctuations the companies provided, in general, excess return on their projects. The results are
highlighted in the following graphs:

20
 20 AMOCO

15
5-Y Avg.
10
3-Y Avg.

5 1996

0
ROE ROC

16 MOBIL
14
12
10 5-Y Avg.
8
3-Y Avg.
6
4 1996
2
0
ROE ROC

25 TEXACO

20

15 5-Y Avg.
%
10 3-Y Avg.
1996
5

0
ROE ROC

21
 20 Chevron

15
5-Y Avg.
10
3-Y Avg.

5 1996

0
ROE ROC

20 Exxon

15
5-Y Avg.
10
3-Y Avg.

5 1996

0
ROE ROC

Firm Amoco Mobil Texaco Chevron Exxon Industry

Current Current Current Current Current Average
ROE (a) 18.13% 15.99% 20.48% 18.16% 17.88% 15.40%
Cost of equity (b) 8.75% 8.97% 8.53% 9.02% 10.07% 9.85%
Excess return on equity (a) – (b) 9.38% 7.02% 11.90% 9.14% 7.81% 5.55%

ROC (c) 14.24% 12.30% 14.01% 13.62% 15.51% 22.46%

Cost of capital (d) 8.20% 8.34% 7.65% 8.45% 9.54% 8.92%
Excess return on capital (c) – (d) 6.04% 3.96% 6.36% 5.17% 5.97% 13.54%

It is clear from the numbers that all companies have been engaging in good projects.
These projects are providing excess return both from the point of view of the stockholders
(excess return on equity) as well as from the point of view of the entire firm (excess return on

22
capital). With regards to the industry average, these companies provided a higher excess return
in the latest period. However, over the last few years their returns are slightly low compared
with industry returns. This could be due to the fact that the chosen companies are larger in terms
of capital, assets, equity and debt than average. Although the earnings are also higher, they did
not off set the denominator of the equation.

c) Converting the excess returns into monetary values: Once we have determined the excess
returns (for the latest period) it is interesting to see how they contributed to increasing the value
of the firms. This is the concept of Economic Value Added (EVA). It is calculated both in terms
of equity (EVA for equity) and in terms of the entire firm value (EVA for firm).

The computation is:

EVA for equity = Excess Return on Equity x Book Value of Equity
EVA for the firm = Excess Return on Capital x Book Value of the Firm
For the companies analyzed the results follow:

Amoco Mobil Texaco Chevron Exxon Ind. Avg.

EVA Equity 1,551 1,301 1,177 1,312 3,399 398
EVA Firm 1,312 2,622 1,817 985 3,177 1,393

The industry itself, as already pointed out in previous sections, is experiencing good
returns and strong earnings. This leads to the creation of a surplus from the companies’ existing
projects. The companies analyzed, being on average larger in size, experience an even larger
surplus.

Although the accounting returns such as the ROE and ROC are good indicators of a
company’s ability to create value, they tend to look at the past performance rather than to future
prospects. However, the companies are enjoying a trend of increasing ROEs and ROCs (as
shown by the comparison of the latest year’s figure and the average of the last four years). Such
trends lead us to believe that the companies are picking better and better projects, and are able to
generate higher returns from their resources today than in the past five years.

23
 There are also a number of other reasons we believe the companies will continue to
increase their value through good projects. In particular:
♦ The companies tend to engage in projects that strictly belong to their core businesses. This
allows them to predict fairly easily the cash flow patterns and thereby reduce risk.
♦ Since there is a relatively small number of competitors in the integrated petroleum industry.
Therefor the companies can enjoy higher margins and take advantage of the positive
macroeconomic trend.
♦ The industry enjoys relatively high barriers to entry due to the high level of capital intensity
of the businesses and of the scarce sources for the product.
♦ The companies are mature and stable in their cash flows and enjoy strong brand equities.
♦ The companies have access to various sources of capital to engage in interesting projects.

However, in order to reinforce the previous qualitative statements, we need the analysis
of the following sections.

24
 PART V
CAPITAL STRUCTURE CHOICES

The purpose of this section is to qualitatively analyze the existing financial mix and to
assess the benefits and costs of debt. We included in debt the short-term debt, long-term debt
and present value of any lease obligations whether operating or capital.

The debt of a company is classified in three categories: short-term debt, long-term debt
and capital and operating leases. A short description of each debt component for the companies
under analysis follows:

a) Short-term debt:
In general for all the companies analyzed the short-term debt consists of Notes Payables and
Commercial Papers.

b) Long-term debt:
Amoco’s long-term debt resides principally with two Amoco subsidiaries – Amoco
Company and Amoco Canada. Amoco Company functions the principal holding company for
substantially all of Amoco’s petroleum and chemical operations, except Canadian petroleum
operations and selected other activities. Amoco’s foreign currency loans are in British Pounds
and in Argentine Pesos.

Mobil has a large amount of Canadian dollar Eurobonds and UK Sterling Eurobonds; it
also has debt in foreign currencies.

As of December 31st, 1996, Texaco was party to a revolving credit facility with
commitments of $1.5 billion with a syndicate of U.S. and international banks, available as a
support for issuance of the company’s commercial papers, as well as for working capital and for
other general corporate purposes. As stated in its Annual Report, Texaco seeks to maintain a
balanced capital structure that will provide financial flexibility and support company’s strategic

25
objectives while achieving a low cost of capital. This is achieved by balancing the company’s
liquidity and interest rate exposure. These exposures are managed primarily through the use of
long-term and short-term debt instruments, which are reported on the balance sheet. However,
off-balance sheet derivative instruments, primarily swaps, are also use as a management tool in
achieving the company’s objectives. These instruments are used to manage identifiable
exposures on a non-leveraged, non-speculative basis.

At year-end 1996, Chevron had $4,425 of committed credit facilities with banks
worldwide, $1,800 of which had termination beyond year one. The facilities support Chevron’s
commercial paper borrowings. Interest on any borrowing under the agreement is based on either
the London Interbank Offered Rate or the Reserve Adjusted Domestic Certificate of Deposit rate.

c) Operating and capital leases

Amoco leases various types of properties, including service stations, tankers, buildings,
and railcars.

For Mobil and Chevron, certain leases include escalation provisions for adjusting prices
that may require higher future rent payments. In this respect, Mobil does not expect that such
rent increases, if any, will have a material effect on future earnings.

Exxon’s leases cover drilling equipment, tankers, service stations and properties.

Millions $ Amoco Mobil Texaco Chevron Exxon

Operating Leases (NPV) 952 1,680 1,715 641 2,779
Capital Leases 76 335 145 338 45

Intuitive Analysis of the Advantages (benefits) and Disadvantages (costs) of Debt:

Advantages:

The five companies have the same marginal tax rate of 35%, so in terms of savings no
company has an advantage over the other one. However, the current amount depreciated by each
firm will make a difference in terms of tax savings. In this respect, Amoco has benefited by
having a greater depreciation expense in relation to the company’s book value. On the other

26
hand, Chevron benefited least by the tax reductions due to its low current depreciation relative to
its book value.

Amoco Mobil Texaco Chevron Exxon

Current Depreciation / Firm BV 4.99% 4.13% 4.28% 3.83% 3.99%
Avg. Current Depreciation / BV 4.24%

The table below shows that Exxon will be able to have more debt since Exxon’s EBITDA
in relation to the value of the firm is the highest in this comparison. This means that the
company can face higher levels of debt. Overall, the five companies under analysis have similar
EBITDA/Firm Values.

Adding to the analysis the figures for the Oil Sector, we see that only Texaco and
Chevron are below the Oil Sector average (not a dramatic difference). Overall, it seems that in
the Oil Sector the numbers for EBITDA/Firm Value are very stable and are around the sector
average (11.77%).

Amoco Mobil Texaco Chevron Exxon

EBITDA 5,875 8,153 4,005 6,209 17,709
Firm Value (Market Value) 45,951 65,897 36,563 57,803 133,375
EBITDA/Firm Value 12.79% 12.37% 10.95% 10.74% 13.28%

Oil Sector Average EBITDA/Firm 11.77%

To continue with the comparison, all five companies are conservative, publicly own, with
wide diverse stock holdings. They have large percentages of shares held by institutional investors
suggesting that there is considerable separation between stockholders and managers. In this
respect, taking on additional debt could add discipline to management. In the same line of
reasoning all the five companies have high cash flows and low leverage that make managers not
to use debt as a source of capital.

Disadvantages:
Since all five companies have cash flows related to the price of oil, a disadvantage of
taking debt relates to their capacities to pay back debt with future cash flows. While we did not

27
find any oil company that went bankrupt in the past 10 years due to a decrease in the price of oil,
the bankruptcy costs are still latent and are something management must consider at the time
they take on debt. To understand this reasoning we pose a question that might help to clarify this
issue: how well did oil companies pay their debt last January, when the oil price went down to
$13 per barrel (1997 oil prices: $23 per barrel)? Companies can hedge their positions when they
have expectations. However, price shocks like the one last January, cannot be expected and
cannot be hedged.

The five companies are paying large dividends. This means that they are reducing the
agency cost by giving back money to the stockholders.

Oil companies in general are companies that need flexibility to expand. Their projects
are expensive and are long-term, (examples of oil projects include pipelines, refineries,
exploration, petrochemical and chemical plants, distribution, and retail gas stations). Therefore,
taking on too much debt for one particular project can hinder their abilities to take on future
projects if the companies used all their borrowing capacity on the earlier projects.

To conclude, since all of the five companies are large corporations and have diverse
stockholding, managers are not very responsive to stockholders. Therefore, taking on debt
would be a good form of discipline for the managers. However, the nature of the oil projects and
their uncertainties regarding future cash flows, make us recommend a cautious course of action
when thinking of taking on debt. In addition, too much leveraging of these companies will
deeply hurt their flexibility to develop future projects.

Ability to Service Debt

FCFF Analysis
Amoco Mobil Texaco Chevron Exxon
Free Cash Flow to the Firm 808 1,388 874 2,378 7,327

The five companies show large free cash flows to the firms that can be used to service
their debts. This is somewhat of a disadvantage because managers could relax on the cushion
provided by the free cash flows, thus taking bad projects.

28
 The table below shows the operating cash flows for each company during the last 10
years. The variability of the change in operating income shows that Exxon is the most stable
company in terms of its operating income. This suggests that Exxon is the company that will
have the least uncertainty on future cash, guarantying its ability to better serve future debt
commitments and to take on more debt.

Operating Cash Flows Amoco Mobil Texaco Chevron Exxon

1996 4,788 6,352 3,762 5,797 12,829
1995 3,809 5,024 2,122 4,075 13,847
1994 4,329 5,362 2,859 2,896 9,852
1993 3,491 5,620 2,362 4,221 11,503
1992 3,020 4,117 2,675 3,914 9,611
1991 3,264 4,894 2,699 3,278 10,942
1990 4,888 4,421 2,519 4,727 10,646
1989 4,054 4,652 1,489 3,046 7,915
1988 4,312 4,029 -58 2,987 10,554
1987 4,156 3,013 2,465 5,787

Variability in 55% 34% 57% 32% 23%

Operating Income

29
 PART VI
OPTIMAL CAPITAL STRUCTURE

The objective of this section is to come up with the optimal financing mix for each firm.

This was first done on a quantitative basis using the Minimization of Cost of Capital
Approach. After the model determined the optimal financing mix, we built constraints to
determine the costs of maintaining a determined credit rating classification.

Since the results of this optimization could be biased by a latest unusual good or bad
year, we ran the same model using a conservative level of EBITDA for each company.

As the results of the quantitative analysis could be way off what is considered normal for
the industry, we enriched our analysis by using a comparative analysis between the firms under
analysis and the oil sector and with the total market as a whole.

1. The Cost of Capital Approach:

The current cost of equity, after tax cost of debt, and cost of capital for the firms under
analysis are (these numbers were calculated in section III):

Amoco Mobil Texaco Chevron Exxon

Cost of Equity 8.75% 8.97% 8.53% 9.03% 10.07%
After-tax Cost of Debt 4.03% 4.23% 4.42% 4.23% 4.03%
Kd 11.65% 13.57% 21.33% 11.66% 8.73%
Ke 88.35% 86.43% 78.67% 88.34% 91.27%
Rating AAA AA A+ AA AAA
Stock Price $83.375 $72.190 $54.375 $77.440 $49.000
Cost of Capital 8.20% 8.34% 7.65% 8.45% 9.54%
MV Firm (millions) $45,951 65,897 $36,563 $57,593 $133,374

30
The optimization process:

Cost of Capital at different financing mixes:

Optimal Cost of Capital

Debt Ratio Amoco Mobil Texaco Chevron Exxon
0.0% 8.53% 8.72% 8.15% 8.79% 9.83%
10.0% 8.25% 8.43% 7.88% 8.49% 9.50%
20.0% 8.04% 8.17% 7.71% 8.27% 9.21%
30.0% 7.88% 8.00% 7.64% 8.11% 9.04%
40.0% 7.81% 7.82% 7.66% 8.08% 8.85%
50.0% 8.10% 7.84% 8.35% 8.31% 8.76%
60.0% 8.69% 7.86% 8.39% 8.60% 9.42%
70.0% 8.72% 8.52% 9.47% 8.91% 9.70%
80.0% 9.18% 8.88% 11.32% 9.26% 9.75%
90.0% 10.63% 8.90% 12.07% 10.72% 10.91%%

Therefore, the optimal ratios and values without constraints for each firm are:

Optimal Ratios
Firm Amoco Mobil Texaco Chevron Exxon
AT Cost of Debt* 5.20% 4.71% 4.71% 5.20% 5.20%
Cost of Equity 9.77% 9.90% 8.62% 9.99% 12.32%
Kd 43% 40% 25% 40% 50%
Ke 57% 60% 75% 60% 50%
Rating BB A- A- BB BB
Cost of Capital 7.81% 7.82% 7.64% 8.08% 8.76%
Value of Firm (1) $48,265 $69,780 $36,624 $60,369 $145,272
Value of Firm (2) $56,533 $77,014 $3,860 $65,709 $160,422
Stock Price (1) $88.120 $78.240 $54.490 $81.660 $53.790
Stock Price (2) $105.09 $87.410 $54.930 $89.790 $59.4890

* The optimal debt ratios and values were calculated with more precision than the 10% ranges.
(1): Assumes no growth.
(2): Assumes growth.

Summary of Important Results:

To have a better assessment of the changes that have to be done on each firm to go from
the current situation to the optimal:

31
 Amoco Mobil Texaco Chevron Exxon
Debt Ratio Current 11.65% 13.57% 21.33% 11.66% 8.73%
Optimal 43% 40% 25% 40% 50%
Rating Current AAA AA A+ AA AAA
Optimal BB A- A- BB BB
Cost of Capital Current 8.20% 8.34% 7.65% 8.45% 9.54%
Optimal 7.81% 7.82% 7.64% 8.08% 8.76%
Stock Price (1) Current $83.375 $72.190 $54.375 $77.440 $49.000
Optimal $88.120 $78.240 $54.490 $81.660 $53.790

(1): Assumes no growth.

This table helps to assess the nature of the changes that must be done in the current
financing mixes to reach the optimal levels.

In the cases of Amoco and Exxon using the higher optimal debt ratios have a strong
downside effect on the credit rating of these companies. The likely increases in the stock prices
of these companies are over 6% (without an assumption of growth).

On the other hand, Texaco, which currently has a debt ratio very close to its optimal
level, does not require a major change in its financing mix. Even though Texaco will probably
experience a reduction on its credit rating, the increase on its stock price is not as attractive as is
the case for the other companies.

2. Building Constraints into the process:

From the previous table it can be seen that maintaining the current level of financing mix
could represent considerable costs to the firm. To represent the cost that would have to be
incurred to achieve or maintain a certain level of credit rating, we calculated:
The cost for each company to maintain its current credit rating will be:

Amoco Mobil Texaco Chevron Exxon

Optimal Value $48,265 $69,780 $36,624 $60,369 $145,272
- Current Value ($45,951) ($65,898) ($35,518) ($57,593) ($133,374)
Difference $2,314 $3,882 $1,105 $2,776 $11,898

32
 As shown, it is costly to maintain the current credit rating and therefore this decision
should not be biased by subjective factors like the ego of management in a well-rated company
(since the value of the firm is maximized at a lower rating level).

3. Sensitivity Analysis (The downside EBITDA):

Since the calculations of the previous optimal ratios were based on the latest available
EBITDA, the whole process of optimization could lead to biased results if this value (the
EBITDA) was abnormally high or low.

To make sure that the results of our process are robust, we repeated the optimization
process but used a conservative level of EBITDA (EBITDA*). This EBITDA* was calculated
for each company using the following formula:

EBITDA* = EBITDA– S(EBITDA)*EBITDA

Where,
EBITDA: is the latest available level of EBITDA
S(EBITDA): is the standard deviation of EBITDA for the last 5 years.

The optimal ratios for each company changed to:

Amoco Mobil Texaco Chevron Exxon

EBITDA $5,875 $8,153 $4,005 $3,993 $17,709
S(EBITDA) 22% 13% 16% 72% 9.92%
EBITDA* $4,578 $7,103 $3,377 $2,886 $15,952
Optimal Debt Ratio 43% 40% 25% 40% 50%
New Optimal Debt 20% 40% 25% 33% 50%
Ratio

After comparing the optimal ratio (using EBITDA) with the optimal ratio using a
normalized EBITDA, we conclude that the majority of the results are robust to changes in the
level of EBITDA. Only Amoco experienced an impressive decrease on its financing mix with the
inclusion of the normalized EBITDA.

33
4. Relative and Regression Analysis:
Our analysis of the optimal financing mix will not be complete if we do not take into
account the levels of debt of companies in the oil sector and the market levels as a whole. Since a
quantitative process does not always make sense, a comparative analysis is always recommended
to increase the level of confidence of the results of the quantitative technique.

a) Relative Analysis; Sector Analysis:

1. Comparison with the average market debt ratio (MV) of the sector:

Amoco Mobil Texaco Chevron Exxon Petroleum Producers

Integrated (*)
Current Debt 11.65% 13.57% 21.33% 11.66% 8.73% 27.59%
Ratio
Optimal Debt 43% 40% 25% 40% 50% 27.59%
Ratio
(*) Source: Damodaran

From this table, it is noticeable that Texaco’s current and optimal levels are very close to
the sector average. Some of the optimal levels of debt require a considerable increase in the
financial leverage of the firms. That is specially the case of Exxon, Amoco and Chevron.
As almost all of the optimal debt ratios are above the sector average, we would like to
compare these results with the entire market.
For the relative analysis (oil sector) we also took the market and book value of 18
companies in the oil sector.

34
Some of the ratios are:

Firm BV Debt Ratio MV Debt Ratio

Pennzoil 53.67% 40.83%
Occidental Petroleum 6.96% 33.33%
Coastal Corp. 53.03% 36.71%
National Fuel Gas 17.78% 31.51%
USX-Marathon Group 32.28% 23.66%
Unocal Corp. 44.11% 18.70%
Atlantic Richfield 65.90% 19.35%
Phillips Petroleum 39.60% 19.35%
Fina Inc. 25.78% 25.37%
Texaco 25.14% 18.03%
Chevron 25.69% 10.71%
Amoco 25.12% 12.28%
Mobil 45.97% 10.71%
Amerada Hess 43.35% 17.36%
Adams Resources & Energy 34.96% 9.91%
Exxon Corp. 35.51% 6.54%
Royal Dutch 14.49% 8.26%
Brown (Tom) Inc. 19.86% 4.76%
Average 33.84% 19.30%

Source: Bloomberg (RV)

To have a better assessment of the Market Value of Debt, we did a descriptive analysis of
the Debt Ratio (MV) for the 18 companies:

Descriptive Statistics
Variable: Debt Rat

Anderson-DarlingNormalityTest
A-Squared: 0.476
P-Value: 0.209

Mean 0.193333
StDev 0.107265
Variance 1.15E-02
Skewness 0.535547
Kurtosis -9.8E-01
0.05 0.15 0.25 0.35 N 18
Minimum 0.050000
1stQuartile 0.107500
Median 0.185000
3rdQuartile 0.267500
95%ConfidenceIntervalforMu Maximum 0.410000
95%ConfidenceIntervalforMu
0.139991 0.246675
0.10 0.15 0.20 0.25
95%ConfidenceIntervalforSigma
0.080491 0.160806
95%ConfidenceIntervalforMedian
95%ConfidenceIntervalforMedian
0.110000 0.244820

35
From the table above we see that
• The average Debt Ratio (MV) is: 19.33%
• Standard Deviation: 10.7% signaling a relative high diversity in the financing mix decisions
of the management of the firms across the sector.
Even though the distribution looks a little spread, the companies under analysis are
between the first and the third quartiles.

b) Regression Analysis; Sector Analysis:

We ran a regression for the oil producing sector (18 companies) and came up with the
following specification for the Debt ratio in market value terms:

Debt Ratio MV: 0.32 - 0.039*Effective Tax Rate - 0.00966*EBITDA/Value -0.070*Sigma(OI)

T-test: (2.59) (-0.24) (-1.14) (-0.64)
R2 : 9.70%
N: 18 companies

As shown, the results are not very exciting. The t-tests show that the coefficients are not
statistically significant. Moreover, the signs of EBITDA/Value and Tax Rate do not make no
much sense.
Besides the bad results of the regression, using the specific values of each firm we came
up with the following predicted debt ratios:

Firm* Amoco Mobil Texaco Chevron Exxon

Tax Rate 28% 49% 20% 41% 33%
EBITDA/Value 11.01% 10.98% 9.74% 10.96% 9.35%
Sigma(OI) 9% 12% 22% 12% 7%
Predicted Debt 30.17% 29.14% 29.59% 29.46% 30.13%
Ratio

(*) Numbers may vary with respect to previous tables because we took Bloomberg values for
this part of the analysis.

36
 Because of the poor results of the regression, one should be careful not to place too much
emphasis on these results.
As almost all of the optimal debt ratios are above the sector average, we would like to
compare these results against the entire market. This is done in the next section.

c) Regression Analysis; Market Analysis:

For a broader comparison, we extended our analysis to include all firms listed in the US
markets. The regression used is:

Debt Ratio = 0.2370 –0.1854 PRVAR + 0.1407CLSH + 1.3959 CAXP – 0.6483 FCP

Where,
PRVAR: Is the standard deviation of the firm value (over 10 years)
CLSH: Closely held shares as a percentage of outstanding shares
CAXP: Capital Expenditures over Book value of Capital
FCP: Free Cash Flow to Firm/ Market Value of Equity

Amoco Mobil Texaco Chevron Exxon

PRVAR 11.88% 8.99% 7.79% 12.15% 4.34%
CLSH 2% 2% 3% 2% 6%
CAXP 8.51% 7.54% 7.92% 5.92% 13.53%
FCP 2.15% 1.76% 1.66% 3.64% 4.62%
Predicted 32.66% 31.70% 32.66% 27.63% 39.63%
Debt Ratio

The debt ratio for Chevron is driven down by its high volatility of Firm Market Value and
by the low level of Capital expenditures in comparison with the rest of the firms.

Summary of results of the debt ratio analysis:

Amoco Mobil Texaco Chevron Exxon

Current Level 11.65% 13.57% 21.33% 11.66% 8.73%
COC Approach 43.00% 40.00% 25.00% 40.00% 50.00%
Sector Ratio 27.59% 27.59% 27.59% 27.59% 27.59%
Sector 30.17% 29.14% 29.59% 29.46% 30.13%
Regression
Market 32.66% 31.70% 32.66% 27.63% 39.63%
Regression
Average 29.01% 28.40% 27.23% 27.27% 31.22%

37
 Since the results of the different approaches vary, we think that the debt ratios of these
companies should move toward the average debt ratios, which are more consistent with the
market and sector levels. Extreme moves out of sector and market standards are difficult to
justify even if you are using the COC approach.

The following graph summarizes the movement from the current debt ratio to the average
optimal debt ratio:

35% Debt Ratios.

30%
25%
20% CurrentLevel

15% Average(Optimal)

10%
5%
0%
n
on
o

il

co
ob

xo
oc

vr
xa

Ex
Am

he
Te

The most dramatic changes are for Exxon and Amoco. The lowest required change is for
Texaco. No matter what type of approach is used, all firms, with the exception of Texaco, seem
to be well below the recommended debt ratio levels.

Finally, we would like to say that even though the analysis objectively (by various
techniques) shows that the companies should increase their levels of debt, this decision is largely
subject to the idiosyncratic characteristics of the management of each company. It most likely
would be difficult to change their minds. Moreover, the reduction of the credit rating on
companies like Amoco and Exxon would be dramatic (from AAA to BB) and extremely difficult
to justify to claim-holders.

38
 PART VII
MECHANICS OF MOVING TO THE OPTIMAL LEVEL

The purpose of this section is to determine how fast these companies should move
towards their optimal financing mix and what should be the general characteristics of the new
debt issued.

This section does not suggest that the companies actually move to the optimal, because
such a decision includes a lot of subjectivity. Therefore, we will only recommend, according to
the characteristics of each company, a possible path to achieve the new optimal debt structure.

1. The Immediacy Question: To answer this question we present a summary table:

Amoco Mobil Texaco Chevron Exxon

Current Level 11.65% 13.57% 21.33% 11.66% 8.73%
Debt
Optimal Level 30.01% 28.40% 27.23% 27.27% 31.22%
(Average)
Cost of Equity* 8.75% 8.97% 8.53% 9.03% 10.07%
ROE 18.13% 15.99% 20.4% 9.14% 17.25%
Cost of Capital* 8.20% 8.34% 7.65% 8.45% 9.54%
ROC 14.24% 12.30% 14% 5.17% 15.10%
Market Value* $35,245 65,897 $36,563 $57,593 $133,374

(*) 1996 Levels

♦ From the table above, it can be said that these companies are large in market value terms (all
over $30,000 million).
♦ In terms of the earnings performance of these companies:
* All of them had excess accounting returns to the stockholders over the corresponding
hurdle rates (ROE > COE).
* All of them (except Chevron) also had excess returns to the firm (all claim holders), i.e.
ROC > COC.

Based on this analysis we conclude that none of these companies are possible targets for
hostile takeovers. Therefore, the recommended path tells us that these firms should continue to

39
take new good projects and increase their debt ratios on a consistent but not quick or rushed
basis.
Moving to the optimal level will require taking good projects and alter in the financing
mix (increasing the level of debt to converge to the optimal). It is important though to
determine what will be the structure of the debt.

2. The Right Financing Mix:

a) Intuitive Analysis:
In part III, we defined the type of projects that these companies will most probably to
take.
Therefore, we consider that the right structure of the debt should be:
• Since the projects taken by these companies clearly have long-term lives, we recommend that
a considerable part of the debt should be long-term debt.
• Part of the debt should be short-term to hedge the variability of the price of the oil and its
effect on the operating income and as a way to maintain flexibility for refinancing long-term
debt.
• To maintain flexibility, some of the debt should be floating rate debt (much of these
companies already have floating rate debt on their books or take swap contracts).
• Since political instability of the main oil producers is always a threat on this sector, some
type of option could be attached to the debt making it more attractive to the bondholders. For
example, if a war breaks out and oil prices go down, the bondholder could have the right to
put the bonds (sell them back to the issuer at a pre-determined price).
• Since these companies are sensitive to the price of oil and other commodities, a link of the
debt to the performance of commodities indexes like the Commodity Research Bureau
(CRB) or directly to the price of oil would attach an attractive value to the bonds. For
example, the floating coupon rate of a bond could be defined as the return of the CRB index
over the last six months. This would create a floating rate debt linked to the commodity
sector.
• Some of the debt should be issued in foreign currency. The currency will depend on the
currency the cash flows of the projects.

40
b) Quantitative Analysis:
One way to look for the debt characteristics is to assess the sensitivity of the firm values
and EBITDA to different macro economic variables. We ran regressions for each company on
an individual basis, but the results were not satisfactory (strange signs of the coefficients, low
levels of significance of the coefficients, etc.). As a way to deal with this problem, we calculated
the averages for the firms under analysis (Value of Firm and EBITDA). The results of the
regressions follow.

Market Value (dependent variable)* Coefficient T-statistic R2

Long term rate -2.17 -1.04 13.40%
GNP 0.87 0.42 2.50%
Dollar 0.631 1.26 18.50%
Inflation 1.02 0.43 2.60%
Oil 0.067 0.54 4.70%

* All variables correspond to year over year changes for the last ten years.

EBITDA (dependent variable)* Coefficient T-statistic R2

Long-term rate 2.92 0.73 7.00%
GNP 1.58 0.41 2.40%
Dollar -0.984 -1.03 13.10%
Inflation 8.81 3.00 56.30%
Oil 0.253 1.19 19.20%

* All variables correspond to year over year changes for the last ten years.

The results shown in the two tables above show that even using averages, values still are
not too satisfactory. The coefficients are all (except EBITDA versus Inflation) non-significant
and the R2 s are very low.
Nevertheless, now the signs are more consistent. For example:
• The GNP coefficient for both equations is positive indicating that the companies are cyclical.

41
• The oil coefficient is positive related to both dependent variables (Change in Value of the
firm and EBITDA), indicating a consistent relationship between the price of the commodity
and the results and the values of the firms.
• The inflation coefficient against EBITDA is positive indicating that a portion of the debt
should be floating rate debt. The negative coefficient of inflation against the Firm seems to
indicate that the effect of the increases in discount rates offset the positive effect of inflation
on EBITDA, muting effect on value.
• We feel that the duration of the firms (the coefficient of Long-term rate against change in
firm value) is too low (only 2.17 years) considering the lives of the projects to be financed.

The results of the quantitative analysis should be considered with caution because the
parameters are not significant and the data is very noisy. We feel that the amount of data could
be expanded (more years should be incorporated to the analysis). Unfortunately, the information
to expand the data was not easy to find and we recommend doing it for further analysis.

As a relative analysis, we calculated the average maturity of the long-term debt of the
firms under analysis. This average is approximately 10 years (10.07 years). We feel that this
average maturity is more consistent with the type of cash flows that are going to be financed by
the debt. Of course, the average duration of this average will be a little lower than 10 years (by
definition of duration), probably somewhere between 7 to 9 years depending on the
characteristics of the debt.

Overall Recommendations on Financing Mix:

Based on the previous analysis, we recommend that the new debt of these companies should
have:
• An average maturity of 10 years (implying an average duration between 7 to 9 years).
• A mix of currencies that match as good as possible the cash flows of the projects conducted
in foreign currencies.
• A mix of fixed and floating rate debt.
• The floating rate debt could be tied to the commodity market performance (as explained
above).

42
 PART VIII
DIVIDEND POLICY

The purpose of this section is to analyze how much the firm has returned to stockholders
in the past, and to assess from a qualitative perspective whether it should return more or less.

Summary of Averages (see Exhibit VIII at the same of this section for more detail):

Amoco Mobil Texaco Chevron Exxon Industry Market

Dividend Yield 3.90% 4.05% 4.62% 3.96% 4.24% 4.41% 1.84%
% Average
Dividend Payout 67.38% 66.93% 84.31% 79.75% 65.38% 53.61% 30.87%
% Average

Dividends Policy and Industry Comparison:

We compared the companies’ dividend yields and payout ratios to the averages of the
petroleum-integrated companies and to the overall market. The five companies under analysis
have paid dividends during the past ten years. The only company that had not bought back stock
in recent years was Texaco (1991 and 1992). Since the five companies are major participants in
the industry, the industry averages reflect their dividend yield ratios as well as their dividend
payout ratios. The comparison with the market shows that these companies have paid more than
the market average and their dividend yields were also much greater than those of the market.

In particular, the five companies have had high and fairly steady earnings, and the
projects undertaken have been within their core businesses. Consequently, each company could
afford to pay high dividends. These companies needs for financial flexibility have been
warranted by their low financial leverage. However, these companies do need flexibility since
the industry is diversified (distribution, pipelines, marketing, exploration, production, chemicals,
petrochemicals, petroleum services, transportation, service stations) and there are a lot of
investment opportunities in the oil sector. In this respect, the companies should be cautious with
their dividend policies so that they will have cash available to continue investing in good projects
(since a good project in the oil sector might be worth several billions of dollars).

43
 Additionally, stock prices had not been affected by the dividend policy, but rather by
macroeconomic trends and by changes in oil prices. Stockholder expectations on the firms are
driven by oil price expectations rather than by the dividend policies of these companies. Future
cash flows are more related to oil price expectations than to dividend policy. Therefore, the need
to signal financial markets is not achieved through dividend policy.

Again, for the five companies, the individual stockholder (not the institutional investor)
seems to be less well off investors who like dividends. This is evidenced by the fact that the five
companies paid higher dividends compared to the market average and their yields were much
higher than market average yields.

Summary of Conclusions:

Dividend Yield Similar to that of the industry average

Much higher than that of the market
average
Dividend Payout Higher than the industry average
Much higher than the market average
Signaling Incentives These companies do not need to use
dividend policy to signal incentives
Type of Stockholders Less well off investors who like dividends
Effects on Flexibility High dividends affect the flexibility due the
nature of the oil projects

44
Exhibit VIII (1)
Historical Dividend Policy
§ Amoco
Dec-1996 Dec-1995 Dec-1994 Dec-1993 Dec-1992
Dividend Paid (M$) 1,287 1,197 1,092 1,092 1,091
Stock buyback 39 704 41 32 29
Total cash to 1,326 1,901 1,133 1,124 1,120
stockholders

Dividend Yield % 3.22 3.36 3.72 4.16 4.51

Dividend Payout % 45.41 64.29 61.04 60.00 128.35
Averages: Dividend Yield = 3.9%
Dividend Payout = 67.38%

§ Mobil
Dec-1996 Dec-1995 Dec-1994 Dec-1993 Dec-1992
Dividends Paid 1,601 1,490 1,411 1,357 1,336
Stock buyback 281 289 263 154 16
Total cash to 1,882 1,779 1,674 1,511 1,352
Stockholders

Dividend Yield % 3.21% 3.24% 4.04% 4.11% 5.07%

Dividend Payout % 53.16% 61.81% 79.54% 64.10% 102.24%

Avg. Dividends Paid $

1,261.60
Average: Dividend Yield = 4.05%
Dividend Payout = 66.93%

§ Texaco
Dec-1996 Dec-1995 Dec-1994 Dec-1993 Dec-1992
Dividend paid 917 892 921 929 927
Stock buyback 159 4 648 0 0
Total cash to 1,076 896 1,569 929 927
Stockholders

Dividend Yield % 3.36 4.08 5.34 4.94 5.36

Dividend Payout % 43.83 124.55 93.47 71.5 88.18
Average: Dividend Yield = 4.62%
Dividend Payout = 84.31%

45
§ Chevron
Dec-96 Dec-95 Dec-94 Dec-93 Dec-92
Dividends Paid 1,358 1,255 1,206 1,139 1,115
Stock buyback 4 4 5 4 382
Total cash to $1,362 $1,259 $1,211 $1,143 $1,497
Stockholders

Dividend Yield % 3.20 3.68 4.15 4.02 4.75

Dividend Payout % 52.09% 134.95% 71.23% 90.04% 50.45%
Average: Dividend Yield = 3.96%
Dividend Payout = 79.75%

§ Exxon
Dec-1996 Dec-1995 Dec-1994 Dec-1993 Dec-1992
Dividends paid 3,920 3,765 3,659 3,630 3,832
Stock buyback 1,139 628 220 323 358
Total cash to 5,059 4,393 3,879 3,953 4,190
stockholders

Dividend Yield % 3.18 3.73 4.79 4.56 4.63

Dividend Payout % 51.66 57.74 71.19 68.08 73.59
Dividend Yield % 3.18 3.73 4.79 4.56 4.63
Average: Dividend Yield = 4.24%
Dividend Payout = 65.38%

46
 PART IX
DIVIDEND POLICY: A FRAMEWORK

The purpose of this section is to assess how much the firm could have returned to
stockholders and whether it should be returning more or less.

1. Affordable Dividends:

In order to determine the amount the companies could have paid in dividends, we have
estimated the average Free Cash Flow to Equity (FCFE) for every company and compared it to
the cash returned to stockholders through dividends and stock buybacks. To calculate the FCFE
for each company, we took into account the average debt ratio of each firm.

Company Average Avg. Dividends & Stock Difference

FCFE Buybacks
Amoco $ 1,215.84 $ 1,320.80 ($ 104.96)
Mobil $ 955.06 $ 1,639.60 ($ 684.54)
Texaco $ 319.19 $ 984.00 ($ 664.81)
Chevron $ 993.96 $ 1,229.67 ($ 235.71)
Exxon $ 4,025.32 $ 3,491.00 $ 534.32

Cash to Stockholders as a Percentage of

FCFE
400%
300%
200%
100%
0%
Am Mo Te Ch Ex
oc bil xa ev xo
o co ron n
Dividends/FCFE

Based on the graphs we see that Amoco, Mobil, Chevron and especially Texaco returned
more cash to their stockholders than they could afford. On the other hand, Exxon had more
conservative dividend policies.

47
 Texaco is the most extreme case regarding the payment of dividends. On average, the
cash returned from this company represented 308% of its Free Cash Flow to Equity, $665 more
than what it should have paid out. On the other hand, Exxon only paid 87% back to its
stockholders, keeping $534 to reinvest in the business.
In general, paying more than what the companies can afford is not sustainable over a long
period of time.

2. Management Trust and Changing Dividend Policy:

Company ROE COE Difference ROC WACC Difference

Amoco 18.13 % 8.75 % 9.38 % 14.24 % 8.20 % 6.04 %
Mobil 15.99 % 8.97 % 7.02 % 12.30 % 8.34 % 3.96 %
Texaco 20.4 % 8.53 % 11.87 % 14.00 % 7.65 % 6.35 %
Chevron 18.16 % 9.03 % 9.13 % 13.62 % 8.45 % 5.17 %
Exxon 17.25 % 10.07 % 7.18 % 15.10 % 9.49 % 5.61 %

To calculate the excess return of the projects to the firm and equity investors, we used the
average ROE and ROC over the last five years and compared it with the last available Cost of
Equity and Weighted Average Capital Cost for each company.

Overall, managers in these firms have been taking on good projects. The good earnings
ratios obtained won the stockholders trust in their companies’ management. This suggests that
fewer dividends should be paid in order to take keep on taking good projects. The investments
made during the period of analysis earned more than the rates required by equity investors.
Regarding the Economic Value Added for these firms, we observe that the trend is to deliver
returns to equity investors that exceed the required rate of return. Exxon has the highest EVA for
equity ($3,152.32 million), while Texaco has the lowest of $1,177.50 million, which is still high
compared to the industry average of $397.74. According to these results, the management of the
firms should have the flexibility and possibility to choose dividend policies most suited to their
companies. The analysis reveals that, in the cases of Amoco, Chevron and especially Mobil,
these companies have been paying more dividends than they could afford. A change in policy is
required, cutting down dividends and reinvesting more in projects in their core businesses.

48
3. Dividend Sector Comparisons:

Company Dividend Dividend Difference Payout Payout Difference

Yield Yield Ratio Ratio
(Sector) (Sector)
Amoco 3.90 % 2.27 % 1.63 % 67.38 % 32.25 % 35.13 %
Mobil 4.05 % 2.31 % 1.74 % 66.93 % 32.58 % 34.35 %
Texaco 4.62 % 1.87 % 2.75 % 84.31 % 28.24 % 56.07 %
Chevron 3.96 % 2.57 % 1.39 % 79.75 % 35.25 % 44.50 %
Exxon 4.24 % 2.74 % 1.50 % 65.40 % 36.92 % 28.48 %

The dividend yield and payout ratios for the sector were calculated taking into account
the weight that each company had in the Petroleum Integrated and Producing sector.

These values suggest that the firms’ dividend yields and payout ratios are high relative to
the sector, with Texaco paying more dividends relative to its earnings. Its payout ratio reaches
84.31%, which is above the sector average by 56.07%. Regarding the dividend yield, Texaco is
also paying the most to its stockholders (given the high amount of dividends paid when
compared to its current stock price of $54).

4. Comparison to the Market:

We used the following regression equations for dividend yields and payout ratios:

Payout = 0.3410 - 0.2109 β + 0.0000033 Mkt.Cap.+ 0.0274 Debt Ratio + 0.1825 ROE – 0.0167
NCEX/TA

R2 = 7.04%

Yield = 0.0189 - 0.0121 β + 0.00000016 Mkt.Cap.+ 0.0056 Debt Ratio + 0.0094 ROE – 0.0028
NCEX/TA

R2 = 10.02%

Where: β = Beta of stock

Mkt. Cap. = Market Value of Equity + Book Value of Debt
Debt Ratio = Book Value of Debt / Mkt. Cap.

49
 ROE = Return on Equity in 1996
NCEX/TA = (Capital Expenditures – Depreciation) / Total Assets

The regression does not have good explanatory power because it explains only 7% to 10% of the
differences in dividend measures.

Plugging in the values for each company we obtain the following results:

Company Dividend Dividend Difference Payout Payout Ratio Difference

Yield Yield (Reg.) Ratio (Reg.)
Amoco 3.90 % 2.24 % 1.66 % 67.38 % 40.20 % 27.18 %
Mobil 4.05 % 2.47 % 1.58 % 66.93 % 47.19 % 19.74 %
Texaco 4.62 % 2.15 % 2.47 % 84.31 % 39.83 % 44.48 %
Chevron 3.96 % 2.37 % 1.59 % 79.75 % 45.07 % 34.68 %
Exxon 4.24 % 3.30 % 0.94 % 65.40 % 65.23 % 0.17 %
*Reg. = Regression output

A common trend is that the five companies are paying more dividends than the average
company in the market. Exxon is the only company that is near the market benchmark,
exceeding it by only 0.17%. Texaco, on the other hand, is paying too many dividends as
indicated by its Payout Ratio of 84.31% and Dividend Yield of 4.62%.

To conclude, Exxon is the only company with the flexibility to increase its dividend
payments, given that its average Free Cash Flow to Equity permits it. In the cases of Amoco,
Mobil, Texaco and Chevron, their dividend policies should be reviewed and adjusted to the real
cash outflows that they can afford.

50
 X. VALUATION

In this final section, our objective is to merge all the analysis conducted in parts 1-9.

The previous sections allowed us to determine the fundamental inputs and assumptions for the
final evaluation of the companies examined in this project. We hereby present the single steps and the
findings of the valuations.

1. Choosing the Right Model:

The three main inputs needed to conduct the valuation of the five companies are:
Growth rate
Type of cash flow
Discount rate

a) Growth rate
The expected growth in earnings per share (EPS) is the basis on which we estimated the
companies’ growth potential. If this figure results considerably higher than the expected growth
of the overall economy (stable growth of 6%), the company is expected to experience a two-
stage growth pattern. This pattern consists of a growth equal to the expected growth in EPS for
the first five years and a stable growth of 6% forever after. In the period of high growth the
discount used in the evaluation is the current cost of capital or equity (depending on the model
used) of each firm. In the period of stable the discount rate employed reflects the beta of a large
stable mature company (Beta =1), and the capital expenditure assumed in the cash flow
computation must offset the level of depreciation. This is the case of Exxon; its current EPS
growth rate is around 7.56%, thus we have assumed this high growth for the first five years and
then a period of stabilization at a rate of 6%.

For all other companies, we chose a stable growth model based on their current EPS
growth, which is close to the nominal one estimated for the economy. In the case of these
companies we assume that their Betas will move towards the industry average which is 0.74.
Two more reasons justify this choice. Firstly, all this companies are large in size and are in a
mature stage; secondly, although the industry enjoys high barriers to entry, the number of

51
projects available are limited and of large scale. These characteristics lead us to believe that
assuming a stable growth from year one is a reliable prediction for the valuation.

The table below illustrated the inputs for the EPS growth computation.
The expected growth in EPS is given by the retention ration (1-Pay-out ratio) multiplied by the
ROE.

Amoco Mobil Texaco Chevron Exxon

ROE 18.13% 15.99% 20.48% 18.16% 17.88%
(1-Payout) 35.71% 18.27% 24.02% 28.77% 42.26%
EPS growth 6.47% 2.92% 4.92% 5.22% 7.56%

b) Type of cash flow

The cash flow to the firm, cash flow to equity and dividends were the options we had
when we chose the type of cash flow to utilize in the valuation. For all the companies analyzed,
except for Amoco, the amount paid in dividends was distant from the free cash flow to equity.
As a consequence, the cash flow to equity is a more reliable signal of the company’s actual
performance than dividends. In addition, we expect the companies’ leverage to remain stable.
This assumption led us to utilize the cash flow to equity for our valuation over both dividends
and cash flow to the firm.

The cash flow to the firm is computed as:

Net income
- (Capital Expenditure-Depreciation)*(1-Debt ratio)
- (Change in Working Capital)*(1-Debt ratio)
= Free Cash Flow to Equity

The table below summarizes the free cash flow to equity computation for the first year.
This is the base value on which the growth rate calculated above is applied.

52
 Company Amoco Mobil Texaco Chevron Exxon
Debt Ratio Discount 13.57 % 21.33 % 11.66 % 8.73 %
EPS Dividend $ 3.76 $ 3.81 $ 3.97 $ 3.02
Net Cap Ex *(1-DR) Model $ 1.97 $ 2.14 $ 1.62 $ 0.69
Changes in WC*(1-DR) ($ 0.26) $ 0.54 $ 0.86 ($ 0.52)
FCFE $ 2.04 $ 1.13 $ 1.49 $2.85

c) Discount rate

Because of the type of cash flow used, the cost of equity is the appropriate discount rate.
Just as a reminder here are the firms’ cost of equity.

Company Amoco Mobil Texaco Chevron Exxon

Cost of Equity 8.75 % 8.97 % 8.53 % 9.02 % 10.07 %

In summary, here are the model used to value the different firms.

Company Model Used

Amoco Stable growth, Dividends
Mobil Stable growth, FCFE
Texaco Stable growth, FCFE
Chevron Stable growth, FCFE
Exxon 2 stage growth, FCFE

2. Valuation:

We then calculated the present value of the Free Cash Flow to Equity for all the companies
except Amoco for which the valuation was made after discounting to the present the value of the
dividends.

Company Current Stock Price Value of Stock Situation

Amoco $ 83.38 $ 99.83 Undervalued
Mobil $ 72.19 $ 54.63 Overvalued
Texaco $ 54.38 $ 30.26 Overvalued
Chevron $ 77.44 $ 60.56 Overvalued
Exxon $ 49.00 $ 49.69 Correctly valued

53
 Current Price per Share vs Value per Share
100
80
60
40
20
0
Amoco Mobil Texaco Chevron Exxon

Current Price Valaution

As a general trend we observe that all the companies with the exception of Exxon and
Amoco are highly over valued. The latter represents a great investment opportunity given its
huge upside potential. The juicy dividends paid by the rest of companies and the expectations
generated by them may be a reason why the valuation differs so much from the current value. An
adjustment in dividend policy for these three companies may discourage investors to take
position in these stocks, driving their prices to a more accurate level and giving the chance to
invest a bigger amount of cash in new projects. At the end this can generate a sustained and
explainable increase in the value of the stock.

54